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        <li class="layui-this"><i class='fa fa-edit'></i> Leases and Bonds</li>
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                You are a senior accountant in the office of the treasurer of Baker Inc. You have been asked to provide a summary of some recent significant financial transactions of Baker as approved by the CFO and the CEO.<br>
                <br>
                One of your staff accountants has prepared the following memo summarizing the financial transactions of Baker. Documentation for the transactions can be found in the exhibits tab.<br>
                <br>
                You need to revise the memo so that it is suitable to present at the next Executive Committee meeting. To revise the memo, click on each segment of underlined text below and select the needed correction, if any, from the list provided. If the underlined text is already correct in the context of the document, select [original text] from the list. If the underlined text should be deleted, select [delete text] from the list.
                <div>&nbsp;
                    <hr></div>
                &nbsp;<br>
                <strong><u>Memo</u></strong><strong>:</strong><br>
                <strong>To:&nbsp; Executive Committee (meeting to be held January 30, Year 1)</strong><br>
                <strong>From:&nbsp; Treasurer's Office</strong><br>
                <strong>Date:&nbsp; January 15, Year 1</strong><br>
                <br>
                The following memo and supporting documents serve to inform the Executive Committee regarding the effects on the financial statement and general ledger of a new lease arrangement and new bond issuance entered into at the beginning of this month.<br>
                <br>
                We have entered into a seven-year lease as the lessee (Reynolds Corporation is the lessor) on a piece of scientific equipment with a fair value of $105,000. <span class="parent mbg {if condition='isset($log.1)'}xbg{/if}"><u>{if condition='isset($log.1) && $log.1.topic_v eq 2'}<s>{/if}The lease must be treated as a capital lease because the equipment's fair value exceeds the present value of minimum lease payments.{if condition='isset($log.1) && $log.1.topic_v eq 2'}</s>{/if}</u></span>
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                                <input type="radio" name="topic_t[1]" value="1" {if condition='isset($log.1) && $log.1.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> The lease must be treated as a capital lease because the equipment's fair value exceeds the present value of minimum lease payments.</em>" ><br/>
                                    <input type="radio" name="topic_t[1]" value="2" {if condition='isset($log.1) && $log.1.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                    <input type="radio" name="topic_t[1]" value="3" {if condition='isset($log.1) && $log.1.topic_v eq 3'}checked{/if} title="<em class='span'>The lease must be treated as a capital lease due to the lack of ownership and bargain purchase options at the end.</em>" ><br/>
                                        <input type="radio" name="topic_t[1]" value="4" {if condition='isset($log.1) && $log.1.topic_v eq 4'}checked{/if} title="<em class='span'>The lease must be treated as a capital lease due to the present value of minimum lease payments versus the asset's fair value.</em>"><br/>
                                            <input type="radio" name="topic_t[1]" value="5" {if condition='isset($log.1) && $log.1.topic_v eq 5'}checked{/if} title="<em class='span'>The lease must be treated as a capital lease due to the length of the lease term relative to the asset's economic life.</em>" ><br/>
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                                                </form> Capital leases require that we record both an asset and a liability on our balance sheet beginning this year, but compared to an operating lease 
                                                <span class="parent mbg {if condition='isset($log.2)'}xbg{/if}">{if condition='isset($log.2) && $log.2.topic_v eq 2'}<s>{/if}the capital lease will result in lower cash flows from operations in Year 1 of $5,545.{if condition='isset($log.2) && $log.2.topic_v eq 2'}</s>{/if}</span>
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                                                                <input type="radio" name="topic_t[2]" value="1" {if condition='isset($log.2) && $log.2.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> the capital lease will result in lower cash flows from operations in Year 1 of $5,545.</em>" ><br/>
                                                                    <input type="radio" name="topic_t[2]" value="2" {if condition='isset($log.2) && $log.2.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                    <input type="radio" name="topic_t[2]" value="3" {if condition='isset($log.2) && $log.2.topic_v eq 3'}checked{/if} title="<em class='span'>the capital lease will result in higher cash flows from operations in Year 1 by $10,655.</em>" ><br/>
                                                                        <input type="radio" name="topic_t[2]" value="4" {if condition='isset($log.2) && $log.2.topic_v eq 4'}checked{/if} title="<em class='span'>the capital lease will result in lower cash flows from financing in Year 1 by $5,545.</em>"><br/>
                                                                            <input type="radio" name="topic_t[2]" value="5" {if condition='isset($log.2) && $log.2.topic_v eq 5'}checked{/if} title="<em class='span'>the capital lease will result in higher cash flows from financing in Year 1 by $10,655.</em>" ><br/>
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                                                                                </form> Our annual payments total $16,200 and for Year 1, consisting of $5,545 in interest and $10,655 in principal. For Year 2, 
                                                                                <span class="parent mbg {if condition='isset($log.3)'}xbg{/if}"><u>{if condition='isset($log.3) && $log.3.topic_v eq 2'}<s>{/if}we will pay $5,070 in interest and $11,130 in principal.{if condition='isset($log.3) && $log.3.topic_v eq 2'}</s>{/if}</u></span>
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                                                                                                <input type="radio" name="topic_t[3]" value="1" {if condition='isset($log.3) && $log.3.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> we will pay $5,070 in interest and $11,130 in principal.</em>" ><br/>
                                                                                                    <input type="radio" name="topic_t[3]" value="2" {if condition='isset($log.3) && $log.3.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                    <input type="radio" name="topic_t[3]" value="3" {if condition='isset($log.3) && $log.3.topic_v eq 3'}checked{/if} title="<em class='span'>we will pay $5,344 in interest and $10,856 in principal.</em>" ><br/>
                                                                                                        <input type="radio" name="topic_t[3]" value="4" {if condition='isset($log.3) && $log.3.topic_v eq 4'}checked{/if} title="<em class='span'>we will pay $4,905 in interest and $11,295 in principal.</em>"><br/>
                                                                                                            <input type="radio" name="topic_t[3]" value="5" {if condition='isset($log.3) && $log.3.topic_v eq 5'}checked{/if} title="<em class='span'>we will pay $4,228 in interest and $11,972 in principal.</em>" ><br/>
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                                                                                                                </form>The only impact on the income statement related to the lease liability will be the interest component of the payments, while the principal component will serve to reduce the liability on our books. 
                                                                                                                <span class="parent mbg {if condition='isset($log.4)'}xbg{/if}"><u>{if condition='isset($log.4) && $log.4.topic_v eq 2'}<s>{/if}The annual depreciation expense associated with the leased asset will be $13,202.{if condition='isset($log.4) && $log.4.topic_v eq 2'}</s>{/if}</u></span>
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                                                                                                                                <input type="radio" name="topic_t[4]" value="1" {if condition='isset($log.4) && $log.4.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> The annual depreciation expense associated with the leased asset will be $13,202.</em>" ><br/>
                                                                                                                                    <input type="radio" name="topic_t[4]" value="2" {if condition='isset($log.4) && $log.4.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                                                    <input type="radio" name="topic_t[4]" value="3" {if condition='isset($log.4) && $log.4.topic_v eq 3'}checked{/if} title="<em class='span'>The annual depreciation expense associated with the lease asset will be $10,268.</em>" ><br/>
                                                                                                                                        <input type="radio" name="topic_t[4]" value="4" {if condition='isset($log.4) && $log.4.topic_v eq 4'}checked{/if} title="<em class='span'>The annual depreciation expense associated with the lease asset will be $13,571.</em>"><br/>
                                                                                                                                            <input type="radio" name="topic_t[4]" value="5" {if condition='isset($log.4) && $log.4.topic_v eq 5'}checked{/if} title="<em class='span'>The annual depreciation expense associated with the lease asset will be $10,556.</em>" ><br/>
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                                                                                                                                                <br>
                                                                                                                                                We have also issued a $500,000 bond maturing in four years and paying interest semiannually. The bond was issued at a discount and ignoring bond issuance costs, the bonds were issued at a total price of $486,698.
                                                                                                                                                <span class="parent mbg {if condition='isset($log.5)'}xbg{/if}"><u>{if condition='isset($log.5) && $log.5.topic_v eq 2'}<s>{/if}The bond was issued with an annual coupon rate of 5.5 percent and interest expense on the income statement will exceed interest payments.{if condition='isset($log.5) && $log.5.topic_v eq 2'}</s>{/if}</u></span>
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                                                                                                                                                                <input type="radio" name="topic_t[5]" value="1" {if condition='isset($log.5) && $log.5.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> The bond was issued with an annual coupon rate of 5.5 percent and interest expense on the income statement will exceed interest payments.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[5]" value="2" {if condition='isset($log.5) && $log.5.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                                                                                <input type="radio" name="topic_t[5]" value="3" {if condition='isset($log.5) && $log.5.topic_v eq 3'}checked{/if} title="<em class='span'>The bond was issued with an annual coupon rate of 4.75 percent and interest expense on the income statement will exceed interest payments.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[5]" value="4" {if condition='isset($log.5) && $log.5.topic_v eq 4'}checked{/if} title="<em class='span'>The bond was issued with an annual coupon rate of 2.375 percent and interest payments will exceed interest expense on the income statement.</em>"><br/>
                                                                                                                                                                <input type="radio" name="topic_t[5]" value="5" {if condition='isset($log.5) && $log.5.topic_v eq 5'}checked{/if} title="<em class='span'>The bond was issued with an annual coupon rate of 2.75 percent and interest payments will exceed interest expense on the income statement.</em>" ><br/>
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                                                                                                                                                </form> We set the fixed coupon rate at a level we were comfortable paying in terms of the semiannual payments, but had market rates on comparable bonds been 
                                                                                                                                                <span class="parent mbg {if condition='isset($log.6)'}xbg{/if}">{if condition='isset($log.6) && $log.6.topic_v eq 2'}<s>{/if}higher at issuance, the initial carrying value of the bond would have been lower and the amortization of the discount would have been lower.{if condition='isset($log.6) && $log.6.topic_v eq 2'}</s>{/if}</span>
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                                                                                                                                                                <input type="radio" name="topic_t[6]" value="1" {if condition='isset($log.6) && $log.6.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> higher at issuance, the initial carrying value of the bond would have been lower and the amortization of the discount would have been lower.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[6]" value="2" {if condition='isset($log.6) && $log.6.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                                                                                <input type="radio" name="topic_t[6]" value="3" {if condition='isset($log.6) && $log.6.topic_v eq 3'}checked{/if} title="<em class='span'>higher at issuance, per period interest expense would be lower and amortization of the discount would be lower.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[6]" value="3" {if condition='isset($log.6) && $log.6.topic_v eq 4'}checked{/if} title="<em class='span'>lower at issuance, the initial carrying value of the bond would have been higher and amortization of the discount would be lower.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[6]" value="4" {if condition='isset($log.6) && $log.6.topic_v eq 5'}checked{/if} title="<em class='span'>lower at issuance, per period interest expense would be higher and amortization of the discount would be lower.</em>"><br/>
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                                                                                                                                                </form> For the journal entry at issuance, the difference between the cash proceeds received at issuance and the bond payable liability will be a debit to Discount on Bonds Payable of $13,302. Going forward, 
                                                                                                                                                <span class="parent mbg {if condition='isset($log.7)'}xbg{/if}"><u>{if condition='isset($log.7) && $log.7.topic_v eq 2'}<s>{/if}the unamortized discount will get smaller each year until maturity.{if condition='isset($log.7) && $log.7.topic_v eq 2'}</s>{/if}</u></span>
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                                                                                                                                                                <input type="radio" name="topic_t[7]" value="1" {if condition='isset($log.7) && $log.7.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> the unamortized discount will get smaller each year until maturity.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[7]" value="2" {if condition='isset($log.7) && $log.7.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                                                                                <input type="radio" name="topic_t[7]" value="3" {if condition='isset($log.7) && $log.7.topic_v eq 3'}checked{/if} title="<em class='span'>amortization will result in debits to the Discount account over time.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[7]" value="3" {if condition='isset($log.7) && $log.7.topic_v eq 4'}checked{/if} title="<em class='span'>the bond payable will increase every period until maturity when it is shown at $500,000.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[7]" value="4" {if condition='isset($log.7) && $log.7.topic_v eq 5'}checked{/if} title="<em class='span'>the differential between interest expense and interest paid will get smaller each period.</em>"><br/>
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                                                                                                                                                </form> The coupon rate is fixed for the life of the bond, but if market rates increase in Year 2, 
                                                                                                                                                <span class="parent mbg {if condition='isset($log.8)'}xbg{/if}"><u>{if condition='isset($log.8) && $log.8.topic_v eq 2'}<s>{/if}the book value of the bond will decline.{if condition='isset($log.8) && $log.8.topic_v eq 2'}</s>{/if}</u></span>
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                                                                                                                                                                <input type="radio" name="topic_t[8]" value="1" {if condition='isset($log.8) && $log.8.topic_v eq 1'}checked{/if} title="<em>[Original text]</em> <em class='span'> the book value of the bond will decline.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[8]" value="2" {if condition='isset($log.8) && $log.8.topic_v eq 2'}checked{/if} title="[Delete Text]"><br/>
                                                                                                                                                                <input type="radio" name="topic_t[8]" value="3" {if condition='isset($log.8) && $log.8.topic_v eq 3'}checked{/if} title="<em class='span'>the book value of the bond will increase.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[8]" value="3" {if condition='isset($log.8) && $log.8.topic_v eq 4'}checked{/if} title="<em class='span'>the market value of the bond will decline.</em>" ><br/>
                                                                                                                                                                <input type="radio" name="topic_t[8]" value="4" {if condition='isset($log.8) && $log.8.topic_v eq 5'}checked{/if} title="<em class='span'>the interest expense will be higher than projected.</em>"><br/>
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                                                                                                                                                        <div><strong>Pop-up 1:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>The lease must be treated as a capital lease due to the length of the lease term relative to the asset's economic life.</u></span><br>
                                                                                                                                                            The lease term is for seven years, and the economic life of the asset is nine years; the lease represents 77 percent of the life of the asset, and since this exceeds the 75 percent threshold, the lease must be treated on Baker's books as capital per GAAP. Had this criterion not been met, the lease still could have qualified for capital treatment if there was an ownership transfer at the end, a bargain purchase option, or if the present value of minimum lease payments exceeded 90 percent of the asset's fair value.<br>
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                                                                                                                                                            <strong>Pop-up 2:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>the capital lease will result in higher cash flows from operations in Year 1 by $10,655.</u></span><br>
                                                                                                                                                            An operating lease will treat the entire payment as a cash outflow from operations. For a capital lease, the interest component in Year 1 ($92,414 x 6% = $5,545) will be a cash outflow from operations while the remainder of the payment ($16,200 - $5,545 = $10,655) will be a cash outflow from financing.&nbsp;<br>
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                                                                                                                                                            <strong>Pop-up 3:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>we will pay $4,905 in interest and $11,295 in principal.</u></span><br>
                                                                                                                                                            The Year 1 payment of $16,200 will be allocated $5,545 to interest and $10,655 to principal. The $10,655 in principal will reduce the outstanding liability from $92,414 (the lower of the PV of minimum lease payments or fair value) to $81,759. Interest of 6 percent on $81,759 will result in $4,905 in interest in Year 2, with the remaining $11,295 allocated to principal.<br>
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                                                                                                                                                            <strong>Pop-up 4:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>The annual depreciation expense associated with the lease asset will be $13,202.</u></span><br>
                                                                                                                                                            The asset will be booked at $92,414 and because the lease is capital due to meeting the 75 percent lease term versus economic life threshold, depreciation will be booked over the life of the lease (7 years).&nbsp; $92,414 divided by 7 = $13,202 per year.&nbsp;<br>
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                                                                                                                                                            <strong>Pop-up 5:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>The bond was issued with an annual coupon rate of 4.75 percent and interest expense on the income statement will exceed interest payments.</u></span><br>
                                                                                                                                                            Semiannual coupon payments of $11,875 on a face value of $500,000 equates to a semiannual interest rate of 2.375%; bonds are issued at annual rates and the annual rate would be 2.375% x 2 = 4.75%.&nbsp; Because the bond was issued at a discount and interest expense is based on market rates at the time of issuance, interest expense will exceed actual interest payments.&nbsp; The market rate at issuance was 5.5% (2.75% x 2).<br>
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                                                                                                                                                            <strong>Pop-up 6:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>lower at issuance, the initial carrying value of the bond would have been higher and amortization of the discount would be lower.</u></span><br>
                                                                                                                                                            Lower market rates relative to the coupon rate would have resulted in a higher initial carrying value for the bond. With a smaller difference between the carrying value and face value, amortization (overall and annually) of the discount would have been lower.<br>
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                                                                                                                                                            <strong>Pop-up 7:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>the unamortized discount will get smaller each year until maturity.</u></span><br>
                                                                                                                                                            As a bond gets closer to maturity, any unamortized discount would get smaller each period until it equals zero at maturity. Amortization of the discount will result in the credits to the Discount account, and because the per-period amortization gets larger each period (while interest paid stays the same), the differential between interest expense and interest paid will get larger each period. Bond payable will be booked initially at $500,000 and remain at that level until maturity.<br>
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                                                                                                                                                            <strong>Pop-up 8:</strong><br>
                                                                                                                                                            <span style="color:#0000ff"><u>the market value of the bond will decline.</u></span><br>
                                                                                                                                                            Changes in market rates have no impact on the book value of bonds or interest expense. The market value will decline because higher interest rates in the marketplace will make a fixed coupon bond less attractive.
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